Monday, August 11, 2008

AAA means very little

An AAA security basically never defaults. historically, the default rates were, oh, 0.03% annualized, so small, a single default would double it. The AAA-BBB spread was abnormally high, but mainly because AAA was treated like US Treasuries, which, historically, was accurate. But that was in the past. Now, AAA means something totally different to investors.

I was talking to someone who works in Commercial Real Estate, and he said they are pretty screwed right now because the AAA rated tranches on deals price at around 400 basis points above Libor. He noted these have never, ever, defaulted. But then, neither did Residential AAA tranches prior to 2007. It seems the Agencies have lost a lot of credibility, and this is going to cause some major problems for a long time, which is a shame because done correctly, these AAA tranches are bullet proof. Unfortunately, these deals have lots of details, so lots of room for errors and bad assumptions. In these cases, eventually you must trust the rating agency, or the issuer, which buyers do not do anymore. This is in contrast to trusting them completely, even as they were asleep at the wheel while underwriters changed the standards of the pools they were rating. So it is quite a change.

Another issue is that many Asset Backed Securities have had little increase in underlying defaults, but as their spreads have widened during this crisis, this has heightened sensitivity to the mark-to-marked risk over and above any concerns about underlying credit quality.

It seems there is a great opportunity for those really knowledgeable to invest in these areas. that is, relying on the rating is now over, but there are ways to analyze these things, and, basically the stupid underwriting practices from 2006 are not inevitable(no income verification, no equity by the asset holder, assuming the collateral would increase regardless).